Here's Why We Don't Think ARB Berhad's (KLSE:ARBB) Statutory Earnings Reflect Its Underlying Earnings Potential

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we'll look at how useful this year's statutory profit is, when analysing ARB Berhad (KLSE:ARBB).

We like the fact that ARB Berhad made a profit of RM35.0m on its revenue of RM123.6m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for ARB Berhad

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So today we'll examine what ARB Berhad's cashflow and its expanding share count tell us about the nature of its profits. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ARB Berhad.

Zooming In On ARB Berhad's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2020, ARB Berhad had an accrual ratio of 0.64. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of RM8.9m despite its profit of RM35.0m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of RM8.9m, this year, indicates high risk. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. ARB Berhad expanded the number of shares on issue by 138% over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out ARB Berhad's historical EPS growth by clicking on this link.

How Is Dilution Impacting ARB Berhad's Earnings Per Share? (EPS)

ARB Berhad was losing money three years ago. The good news is that profit was up 248% in the last twelve months. But EPS was far less impressive, dropping 19% in that time. This is a great example of why it's rather imprudent to rely only on net income as a growth measure. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if ARB Berhad's earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

Our Take On ARB Berhad's Profit Performance

As it turns out, ARB Berhad couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For all the reasons mentioned above, we think that, at a glance, ARB Berhad's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing ARB Berhad at this point in time. For example, we've found that ARB Berhad has 4 warning signs (2 shouldn't be ignored!) that deserve your attention before going any further with your analysis.

Our examination of ARB Berhad has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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